This post gives you the scoop on double diagonals, a versatile options strategy that not many traders know about. We’ll discuss what this strategy offers (a way to trade on a neutral market outlook), its risks, where you can enter the order (on TradeKing’s new double diagonal order-entry screen) and why you might consider this trade (if you want to add an additional time decay feature to your iron condors).

A caveat before we start: Multiple leg options strategies involve additional risks and multiple commissions, and may result in complex tax treatments.

Double diagonals are like a stew made of many leftovers: they include bits and pieces of lots of other options strategies. The main ingredients are the buying and selling of options, we then add in a cup of multiple expirations, a cup of multiple strikes and a ½ cup of calls and ½ cup of puts. Lastly we add a dash of iron condor for taste and voila – we have a double diagonal.

Also like a tasty stew, double diagonals offer a taste of many good aspects of an option strategy at once: they’re non-directional, they prosper with time decay, they offer limited and known risk (max potential loss is equal to the width of the widest spread, plus the debit paid), and margin relief.

Real-world example: IBM

Let’s jump right in with an example. Since double diagonals like less volatility versus more, most DD traders like to use index options for the strategy. (Indexes have historically proven to be less volatile over time than individual stocks – you can learn more about index options here.) That said, I should mention that DD’s can be done on all the possible underlyings (stocks, ETFs, indices) -- whatever you like. Today we are going to use IBM, a favorite stock for both calendar and diagonal strategies.
 
On 5/1/09 IBM closed at 104.61

1)    Buy 1 IBM July 120  Call   @  1.00
2)    Sell 1 IBM June 115  Call   @   .95
3)    Sell 1 IBM June 95     Put  @  1.75
4)    Buy 1 IBM July 90     Put  @  1.80
                         Net debit of           .10

This is a basic example with 49 days remaining in the June options and 77 days in the July options. These varying expiration dates make this example a little oddball compared to a straight 30- or 60-day diagonal, but it still works. Also, I hope no-one minds that I gave us a GREAT hypothetical fill on this trade to keep the math simpler.
 
Because you have the multiple expirations it will leave you with many options at the June expiration (if the trade is going with you). Ideally we would’ve like to do the trade for a small credit to the account, but the quotes just didn’t add up so the example here is done for a small net debit of 10 cents to start.  So the risk reward spells out like this:

Max Risk = width of the widest spread plus the debit paid
(120 – 115 = 5) or 5 plus .10 or 5.10

Keep in mind that this DD is constructed of two spreads, each 5 points wide:

1)    Buy 1 IBM July 120  Call   @  1.00
2)    Sell 1 IBM June 115  Call   @   .95

Then…

3)    Sell 1 IBM June 95     Put  @  1.75
4)    Buy 1 IBM July 90     Put  @  1.80

(Each contract represents 100 shares of stock, for a debit of $10.00)

Margin requirement is 5 points (potential loss on one of the spreads)

At the June expiration we would like the stock to be between 115 and 95, which leaves a 20-point range in which IBM can profitably land.

A tale of two exit possibilities

At this point we have a few choices. If IBM is trading within the range, most traders will roll the June options out to the July expiration period, making this an iron condor. You should be able to do this for a nice credit if the stock is finishes between the range. Specifically, we’d buy to close the two June options and sell to open two July options, most likely with the same strikes as the June options. The credit received from this sale would become the potential profit of the trade less commissions. (Assuming a one contract double diagonal spread, to enter and exit, rolling June to July, and July expiring worthless, the total commission costs would be $44.80.)

The closer to the expiration the roll occurs the more potential for a large credit to be brought in. If IBM closes at the either of the June strikes at the June expiration, the strategy will be at the most profitable point for the trade during the June expiration, as the P&L graph below shows the trade would be up approximately $140. It might make sense to just close the entire trade at this point and take the profit instead of rolling out to the next month. (Commissions for this scenario would also be $44.80.)

Another choice is to let the near-term options expire and remain long the strangle for the 10 cent debit paid. In essence, that move suggests you’re hoping IBM will move a lot in either direction during the month of July. (Commissions for this scenario would be $33.60 since we’re assuming June contracts would expire worthless.)



As you can see this is a trade with many dynamics to it. However you exit this strategy, you’ll need to plan for the possibility of early exercise as the June expiration approaches. This post on early exercise should keep you on your toes. (Actually, this post is a must-read for anybody dabbling in multi-expiration trades like calendars or single diagonals).

The double diagonal can present many interesting scenarios at the expiration of the June option contact, but it can also bring many surprises. You should have your strategy mapped out on how to handle them when they present themselves.

Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

[image: Playground tic-tac-toe and square by frozenchipmunk on flickr]

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.

Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.  

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Brian, you mentioned double diagonals like less volatility not more and it sounds reasonable, we do not want to touch the short options. At the same time the position is long further month options and will have a positive vega, in other words rise in volatility will benefit the position. How does it work?

Double diagonals do have a positive vega.  I think Brian was referring to the fact that when you place the double diagonal trade you would prefer to have lower IV in the underlying.  If the IV is high but the trend is downward, like we've seen in the past few months, then the double diagonal won't leave you with much of a profit at expiration, even if your forecast for the index/stock price is correct.  In markets where the IV is coming in, then it would be more profitable to use an iron condor.  Double diagonals can offer you some protection against increasing volatility, you just don't want too much of a move in one direction because you are still short the front month option which is closer to the money, and thats where the majority of your risk is with a trade where you are a net seller of options.

What I like about Double Diagonals is the ease in adjustment.  Often at an adjustment point I will simply make it a semi double calender and roll my other spread up.  When Vols are high I will often buy the wings out farther to give me slightly negative vega.  This can be expensive but sometimes worth it when you are dealing with wacky vols.  Fortunately the vols have come in somewhat now.

The important thing in trading these is picking the right underlying.  Brian, IBM is a wonderful product along with some others.  I want to get good theta like a calender. 

If I am successful with a double diagonal I probably would have been successful with another strategy too as the underlying will likely behave.  70 % of this play is getting the right underlying. 

I like to place these 40-45 days out prior to expiration and look for a 20-25% profit target.  I will never go into expiration week with this play and will only hold until the Friday before expiration;max.